A blog dedicated to real estate matters, finance as well as general economics and political economics issues. Posts written by Luigi Frascati, B.Econ. Your comments and suggestions are appreciated.

Friday, December 08, 2006

China's Incredible Real Property Appreciation

Now, THAT’s what I call a real estate bubble!

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Readers who routinely follow my articles on Real Estate Economics are fully aware of my position on real estate bubbles in North America.

A real estate bubble occurs when prices of real capital assets become so absurdly high that consumers either refuse or cannot afford to purchase, thus sending demand tumbling down. This has not happened in North America's real estate markets, where we have assisted at either a slowdown in property appreciation or a depreciation of values in line with the Fed's forecast of late 2005 and the beginning of the year, as well as with those of many economic analysts - including myself. This is the reason why this time around I wanted to give an example of a true real estate bubble.

As reported by the official Xinhua News Agency, there is a growing concern among top officials of the People's Republic of China that surging prices in major cities threaten to create economic overheating and serious social unrest. This has prompted a new crackdown by the Chinese leadership on property speculation. The National Development and Reform Commission (NDRC), the state planning agency, in fact reports that in North-eastern Dalian in the first three months of this year prices for new properties jumped 15 percent from a year earlier, and that prices in the Southern boomtown of Shenzhen gained 10 percent in the same period. While in Beijing, says the NDRC, prices were up 17 percent amid euphoria over the forthcoming 2008 Olympics in the Chinese capital.

But before you hop on to the first flight for Beijing, read this. Chinese economists say that owning an apartment is now an unrealistic dream for large numbers of urban residents who are falling further behind as home prices surge. The core of the problem appears to be the disparity between prices of real capital assets and wages. More specifically, the average apartment in the city costs 13 times the annual average salary.

Now, that's what I call a real estate bubble!

The main reason for this huge levitation of prices is speculation. Speculation is one of the many forces that act on capital at any given time. In theoretical Economics, speculation is defined as ‘the acquisition of financial or capital assets made solely to quickly profit from fluctuations in their prices, or of goods or commodities with no real intent to consume or otherwise use them for production'. Basically what many Chinese speculators are doing is flipping apartments, even before they are built. NDRC reports that many developers have gone even as far as creating independent companies that they themselves control, the sole purpose of which is to buy the apartments the developers are in the process of building and then resell them with a markup, thus inflating prices.

Property is a big driver of Chinese economic growth, and runaway investment in the real estate sector has contributed to signs of a broader overheating. The economy grew by a red-hot 10.2 percent (annualized) in the first quarter of the year from a year earlier, when it grew to the tune of 8 percent per year. Concern about too-rapid growth has prompted the government to raise bank lending rates by 0.27 percentage points last month to discourage borrowing and reduce investment. Officials fear that overheating could lead to a sudden economic crash. Additional measures are in the wings, including hefty increases in property taxes, again to take aim at property developers who hoard land and buildings, a practice that creates artificial shortages and drives up prices.

Scarier still is the social unrest that the leadership fears if the economy does not slow down to more manageable levels. This is due to a growing imbalance of wealth rampant in China's population of 1.3 billion people, wherein thirty-five percent of the population lives in the cities and sixty-five percent inhabits the countryside. There is a system of residence controls, so that if one is lucky enough to be born in a city - and registered as a city dweller - it is easier to get into university or to work at all the large companies and government agencies in the city. If, conversely, one is registered as a rural person there are very severe restrictions on where he can live and work. And this is actually the biggest human rights problem in China today. The majority of this population of 1.3 billion people consists, by law, of second-class citizens who live for the most part in conditions of abject poverty, in rural huts many of which do not even have running water. One can imagine how these people feel when they look at the way their urban counterparts live.

The economic ripples and effects that a speculation in grand style such as this have on market wealth are indeed humongous. Market wealth is defined as ‘the combination of materials, labour, land, services and technology in such a way as to capture a profit' (Adam Smith). The aftershocks of a bubble of this size that bursts are usually terminal and irreversible: market wealth disappears, it vanishes entirely. And it takes forever to re-build it, right from scratch. Here in the West, the greatest example in recent times is the infamous Black Monday - October 19, 1987 - when the Dow Jones collapsed 22.6 percent in value in a single day! It took nine years for Wall Street to lure investors back.

But then, how much is too much? Well, consider this: at the top end of the market, even the smallest apartment in a building next to Citigroup's skyscraper on Shanghai's waterfront is stunningly expensive. Complete with all-copper doors and Swarovski crystal lights it costs about USD 2 million or USD 1,670 per square foot - and no fireplace.